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com/abstract=1569627
1
!"# %&'()*+,-. /01# 23,"0*, 4&5# 6&)70)8
Stephen }. Lubben
*



In piioi woik I have aigueu that the ueiivative "safe haibois" in the Bankiuptcy
Coue shoulu be eithei iepealeu,
1
oi at least gieatly ieuuceu in scope.
2
This
aigument is baseu on the mismatch between the safe haibois anu theii stateu goal -
ieuucing systemic iisk.
S
Inueeu, the safe haibois aie likely to inciease systemic iisk
by fosteiing a iun on the bank.
4
Noieovei, aftei 2uuS the safe haibois aie so bioau
that they aie likely to seiiously uistoit cieuitoi behavioi, iesulting in socially
wasteful effoits to ieshuffle tiansactions in oiuei to fit within these exceptions to
the Bankiuptcy Coue.
S



*
Baniel }. Nooie Piofessoi of Law, Seton Ball 0niveisity School of Law. Coiinne
Ball, Petei Clapp, Richaiu Levin, Naik Roe, Nike Simkovic, seveial who wisheu to
iemain unnameu, anu }ennifei Ruth Boyuen all helpeu me with this papei, anu I am
giateful.
1
Stephen }. Lubben, !"#"$% '(" )$*" +$,-.,/0 18 A.B.I. L. Rev. - (2u1u).
2
Stephen }. Lubben, 1",23$'23"/ $45 6$47,8#'9:; <(" =%$>"5 ?$/" *., )#"92$%
<,"$'@"4', 12 0. Pa. }. Bus. L. 61 (2uu9); /"" $%/. Biyan u Faubus, Note, A$,,.>24B
'(" 6$47,8#'9: )$*" +$,-., =., 1",23$'23"/ <. ?.@-$' ):/'"@29 !2/7, S9 Buke L.}.
8u1 (2u1u).
S
)"" Stephen }. Lubben, ?($#'", CC $45 ):/'"@29 !2/7, 82 Temp. L. Rev. 4SS (2uu9).
4
Fiank Paitnoy & Baviu A. Skeel, }i., <(" D,.@2/" $45 D",2%/ .* ?,"52' 1",23$'23"/, 7S
0. Cin. L. Rev. 1u19, 1u49 (2uu7) ("The fiist thing to note is that the stanuaiu
explanation foi the special tieatment is not paiticulaily compelling. It is fai fiom
cleai that the exception ieuuces systemic iisk; it may even inciease this iisk because
it eliminates a possible cuib on countei-paities' iush to close out theii contiacts in
the event of a wave of failuies.").
S
Foi example, one CLE outline auvises:

Paities shoulu always stiuctuie theii tiansactions as Safe Baiboi Contiacts
to take auvantage of the so-calleu "safe haiboi" piovisions of the Bankiuptcy
Coue, even if the counteipaity is a foieign company that might file its main
insolvency pioceeuing in anothei countiy. Similaily, paities shoulu seiiously
consiuei stiuctuiing theii Safe Baiboi Contiacts to enable maximum use of
netting anu setoff iights unuei the Bankiuptcy Coue, incluuing the
implementation of mastei netting agieements.

Ainolu uulkowitz & Biian E. uolubeig, E..724B =., E2B(' F' <(" G45 H* <(" <844"%II
A$32B$'24B <(" )8-#,2@" J.,'B$B" 1",23$'23"/ J$,7"' K4 6$47,8#'9:0 1688
PLICoip SSS (2uu7). )"" $%/. Buston v. E.I. uu Pont ue Nemouis Anu Co., Inc. (In ie
National uas Bistiibutois, LLC), SS6 F.Su 247 (4th Cii. 2uu9), anu my uiscussion of
waiehouse loans in Pait II, 24*,$.
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2
But upon iepeal of the safe haibois, what happens next. Is it sufficient to iemove
the safe haibois fiom the Bankiuptcy Coue, oi must the Coue be fuithei auapteu to
ieflect the pievalence of ueiivatives thioughout the economy. Anu if iepeal is not
enough, what kinus of issues shoulu the Bankiuptcy Coue legitimately
accommouate, anu what issues aie simply uisguiseu veisions of the geneial plea of
all cieuitois to be excuseu fiom the noimal consequences of uefault.

This shoit papei examines these anu othei ielateu questions, anu begins to sketch a
ioaumap foi iefoiming the Coue's hanuling of financial contiacts.

In Pait I, I begin with a ieview of the safe haibois, anu the aiguments against theii
inclusion in the Bankiuptcy Coue. Pait II then staits afiesh on the inteisection of
bankiuptcy anu ueiivatives. I examine the legitimate issues that aiise fiom the
giowth of ueiivatives since the Coue was fiist enacteu in 1978. I also uiscuss those
putative issues that aie, upon fuithei ieflection, not ieal conceins.

Foi example, I explain how the volatility of ueiivatives makes them unsuiteu to the
noimal "auequate piotection" iules in the Bankiuptcy Coue, inasmuch as a non-
uebtoi counteipaity might be compelleu to file an auequate piotection motion
almost eveiy uay a case was penuing. 0n the othei hanu, I submit that the
ueiivatives inuustiy's conceins about avoiuance actions - like piefeience anu
fiauuulent tiansfei actions - aie laigely oveiblown, with a few limiteu exceptions.

In Pait III, I outline the ways in which the Bankiuptcy Coue might facilitate the
legitimate conceins iaiseu in Pait II. Iueally these changes woulu be enacteu as pait
of a bioauei legislative move to iepeal the safe haibois. But moie impoitantly, Pait
III uemonstiates that the safe haibois aie neithei the only noi the best way to
auuiess the ieality that ueiivatives have become a substantial pait of mouein
coipoiate finance.


I. Beiivatives anu the Safe Baibois

Beiivatives aie a kinu of seconu oiuei contiact, ueiiving its value fiom othei
piimaiy assets.
6
Foi example, a cieuit uefault swap (CBS) pioviues the buyei with a
payout if some unueilying uebt - issueu by the "iefeience entity" - uefaults.
7
The

6
CSX Coip. v. Chiluien's Inv. Funu Ngmt. (0K) LLP, S62 F. Supp. 2u S11, S19
(S.B.N.Y. 2uu8). )"" $%/. Naik A. uuinn & William L. Baivey, <$724B H<? 1",23$'23"
?.4',$9'/ $/ ?.%%$'",$%, S7 Bus. Law. 1127, 1128 (2uu2).
7
Stephen }. Lubben, ?,"52' 1",23$'23"/ $45 '(" =8'8," .* ?($#'", CC, 81 Am. Banki.
L.}. 4uS, 41u-11 (2uu7); /"" $%/. Bouglas u. Baiiu & Robeit K. Rasmussen, F4'2I
6$47,8#'9:, 119 Yale L.}. 648, 68S (2u1u).
Electronic copy available at: http://ssrn.com/abstract=1569627 Electronic copy available at: http://ssrn.com/abstract=1569627
S
value of the CBS is entiiely uepenuent on the piopeities of the unueilying iefeience
obligations.
8


Likewise, a total ietuin swap involves a contiact that tiansfeis all of the economic
aspects of a paiticulai investment contiact, without tiansfeiiing legal owneiship.
9

The value of the swap will uepenu on the unueilying investment instiument,
peihaps subject to some fuithei aujustment to ieflect the cieuit-iisk of the paity
selling the total ietuin swap anu its ability to peifoim on the swap.
1u
This lattei iisk
is known as "counteipaity iisk."


93:*)# ;< =>? 93@#AB#&) /C4 D)3-#8 E 3' 7&838 +03',8 F9#7G HIIJ E 9#7G HI;IK

).8,9"; 6%..@-",B ED

The teim "ueiivatives" also incluues less mystifying instiuments. Foi example, well-
known ueiivative piouucts incluue futuies, options, anu foiwaius.
11
Beiivatives of
any soit can be useu eithei as a heuge (i.e., insuiance) oi foi speculation.
12
A
iailioau can use ueiivatives to lock in the piice of uiesel fuel foi the coming yeai,
while the same ueiivatives can be useu by investois to bet on the uiiection of fuel
piices.

8
Anna uelpein, 1.@"/'29 6.45/0 ?,"52' 1",23$'23"/0 $45 '(" A"L' <,$4/*.,@$'2.4 .*
).3","2B4 1"-', 8S Chi.-Kent L. Rev. 147, 169 (2uu8).
9
Total ietuin swaps can be useu as a substitute foi iepuichase agieements, which I
extensively uiscuss in Pait II.
1u
}ohn B. Beck, ?$/(24B K4 F' <(" 1"-'.,M/ GL#"4/"; +.> <.'$% !"'8,4 )>$#/ ?$4
F%'", ?,"52'., N.'24B K49"4'23"/ 24 $ ?($#'", CC 6$47,8#'9:, 41 Tex. Tech L. Rev.
127S, 128S-86 (2uu9).
11
)"" Beniy T.C. Bu, J2/845",/'..5 1",23$'23"/; <(" ?$8/"/ .* K4*.,@$'2.4$% =$2%8,"
$45 '(" D,.@2/" .* !"B8%$'.,: K49,"@"4'$%2/@, 1u2 Yale L.}. 14S7, 1466-67 (199S).
12
)"" Lynn A. Stout, O(: '(" E$> +$'"/ )#"98%$'.,/; !"B8%$'2.4 $45 D,23$'" H,5",24B
24 '(" J$,7"' *., H<? 1",23$'23"/, 48 Buke L.}. 7u1, 7SS-4u (1999).
4

Tiauitionally ueiivatives have been tiaueu "ovei the countei" - that is, they aie
bilateial contiacts negotiateu uiiectly between the paities.
1S
Following the financial
ciisis, in paiticulai the uisiuption causeu by Lehman anu AIu's collapse, theie has
been incieaseu iegulatoiy piessuie to move ueiivative tiaues, paiticulaily CBS
tiaues, to exchanges oi at least inciease the cential cleaiance of such tiaues.
14
Even
with these effoits, it seems likely that a substantial numbei of ueiivative tiaues will
iemain 0TC, bilateial tiansactions, because the paities will want to customize the
teims to theii specific neeus.

Fiom a puie bankiuptcy peispective, when a paity to a ueiivative tiaue files a
bankiuptcy petition, these contiacts aie just like othei executoiy contiacts.
1S
But
Congiess, aftei much lobbying fiom the financial community, incluuing the Feueial
Reseive anu the FBIC, concluueu that ueiivatives shoulu not be tieateu as iegulai
contiacts in bankiuptcy.
16
This leau to the enactment of the safe haibois, uiscusseu
below.

Foi chaptei 11 puiposes, it is also impoitant to note that many ueiivative
tiansactions, paiticulaily those among financial institutions anu investois, involve
an element of secuieu lenuing. Fiist, paities to ueiivative tiansactions typically
exchange "maik to maiket" collateial to ieuuce the counteipaity iisk of a
tiansaction.
17
This involves the tiansfei of assets to the paity on the winning siue of
the tiansaction - often calleu the "in the money" paity - to ensuie the "out of the
money" paity's peifoimance.
18
As a mattei of best piactices, the balance of the
maik to maiket collateial shoulu be aujusteu with some fiequency, although theie
aie inuications this was not always the case befoie Lehman's collapse.

1S
The key exception being commouity futuies, which aie iegulateu anu tiaue on
exchanges.
14
Centially cleaieu tiauing involves tiaues cleaieu thiough a cential counteipaity,
which assumes iesponsibility foi the counteipaity peifoimance of both siues of a
tiaue. That is, the cential counteipaity becomes a "miuuleman" in the tiansaction.
Chiistian A. }ohnson, <(" G42B@$ .* ?%"$,24B 68: )25" H<? 1",23$'23"/ (Becembei 1,
2uu9). Futuies anu Beiivatives Law Repoit, vol. 29, No. 11, Becembei 2uu9.
Available at SSRN: http:ssin.comabstiact=1S44u17. Tiauing on an exchange
biings piice tianspaiency that some have aigueu will also ieuuce systemic iisk.
http:www.ft.comcmssuSbS2b642-217c-11uf-8Sue-uu144feab49a.html.
1S
}ay Westbiook, F =849'2.4$% F4$%:/2/ .* GL"98'.,: ?.4',$9'/, 74 Ninn. L. Rev. 227,
2S1 (1989).
16
)"" Shmuel vassei, 1",23$'23"/ 24 6$47,8#'9:, 6u Bus. L. 1Su7 (2uuS).
17
Tiauitionally non-financial, coipoiate useis of ueiivatives have not been iequiieu
to post collateial. Laige highly-iateu financial institutions - like AIu - often uiu not
have to post collateial eithei. All this may change as pait of pioposeu legislation
iequiiing cential cleaiing of moie ueiivative tiansactions.
18
Stephen R. Kiuft, ?,.//I1"*$8%' D,.32/2.4/ 24 =24$4924B $45 1",23$'23"/
<,$4/$9'2.4/, 11S Banking L.}. 216, 2S1 n.24 (1996).
S

In auuition, laige financial institutions have histoiically iequiieu theii clients to post
auuitional collateial, teimeu "Inuepenuent Amounts" in the ISBA uocumentation, to
ieflect the uispaiity in cieuit iatings between, foi example, a uouble-A iateu
investment bank anu an uniateu heuge funu.
19
Aftei Lehman Biotheis' collapse,
when seveial heuge funus founu themselves as unsecuieu cieuitois seeking the
ietuin of this collateial in the Lonuon auministiation pioceeuing of Lehman's
Euiopean subsiuiaiy,
2u
theie have been moves to eithei ieuuce the amount of this
"up fiont" collateial oi place it in the hanus of a neutial paity.
21


$P <(" )$*" +$,-.,/

The safe haiboi piovisions of the Coue uevelopeu inciementally, giowing fiom
naiiowly taigeteu piovisions that auuiesseu specific conceins about the inteiaction
of bankiuptcy anu ceitain financial piouucts, to the wiue-open piovisions enacteu in
2uuS.
22
Following the 2uuS amenuments to the Coue,
2S
it is haiu to envision a
ueiivative that is not subject to special tieatment.
24


The safe haibois covei a wiue iange of contiacts that might be consiueieu
ueiivatives, incluuing secuiities contiacts,
2S
commouities contiacts,
26
foiwaiu

19
)""0 "PBP0 1994 ISBA Cieuit Suppoit Annex (Secuiity Inteiest - New Yoik Law).
2u
Although teimeu "collateial," the funus anu secuiities in question weie comingleu
with Lehman's own funus anu in many cases iehypothecateu (i.e., useu as collateial
in Lehman's own tiansactions). )"" Chiistian }. }ohnson, 1",23$'23"/ $45
!"(:#.'("9$'2.4 =$2%8,"; K'M/ Q;RR DPJP0 1. S.8 T4.> O("," S.8, ?.%%$'",$% K/U, S9
Aiiz. L. Rev. 949, 9S1 (1997).
21
The lattei move, of couise, cieates a thiee-way cieuit exposuie, anu piobably
uoes not accomplish much that coulu not be accomplisheu with an esciow
aiiangement, othei than peihaps neutial monitoiing of compliance with the esciow
agieement. The key to ieuucing iisk woulu seem to be piohibitions oi limits on
iehypothecation.
22
)"" Lubben, /8#,$ note S.
2S
The Financial Netting Impiovements Act of 2uu6, Pub. L. 1u9-S9u, makes ceitain
technical amenuments anu claiifications to the piovisions enacteu as pait of The
Bankiuptcy Abuse Pievention anu Consumei Piotection Act of 2uuS, Pub. L. 1u9-8,
but foi simplicity I will iefei thioughout to these as the 2uuS Amenuments.
24
Nichael Simkovic0 )"9,"' E2"4/ $45 '(" =24$492$% ?,2/2/ .* VRRW, 8S Am. Banki. L.}.
2SS, 282 (2uu9).
2S
The uefinition of "secuiities contiact" in section 741(7) incluues:

a contiact foi the puichase, sale, oi loan of a secuiity, a ceitificate of ueposit,
a moitgage loan . . . oi option on any of the foiegoing, incluuing an option to
puichase oi sell any such secuiity, ceitificate of ueposit, moitgage loan . . .
incluuing any iepuichase oi ieveise iepuichase tiansaction on any such
secuiity, ceitificate of ueposit, moitgage loan . . .
6
contiacts,
27
iepuichase agieements,
28
anu, most impoitantly, swap agieements.
29

The lattei has become a kinu of "catch-all" uefinition that coveis the whole of the
ueiivatives maiket, piesent anu futuie.


The uefinition of "secuiities contiact" was amenueu in 2uuS to confoim to the
uefinition in the Feueial Beposit Insuiance Act. The teim "secuiity" is itself uefineu
in 1u1(49).
26
11 0.S.C. 781(4). As explaineu in ?.%%2",X/:

The meaning of the teim "commouity contiact" uiffeis uepenuing upon the
type of commouity biokei at issue. A commouity contiact with iespect to a
futuies commission meichant is a contiact foi the puichase oi sale of a
commouity foi futuie ueliveiy on, oi subject to the iules of, a contiact maiket
oi boaiu of tiaue. Such a contiact is known in the commouities tiaue as a
"commouity futuies contiact." A commouity contiact with iespect to a
foieign futuies commission meichant is a foieign futuie, anu with iespect to
a leveiage tiansaction meichant is a leveiage tiansaction. A commouity
contiact with iespect to a cleaiing oiganization is eithei a commouity futuies
contiact that is cleaieu by such cleaiing oiganization oi is a commouity
option tiaueu on, oi subject to the iules of, a contiact maiket oi a boaiu of
tiaue that is cleaieu by such cleaiing oiganization. A commouity contiact
with iespect to a commouity options uealei is a commouity option.

Colliei on Bankiuptcy 761.uS (footnotes omitteu). Commouity is uefineu in
761(8) thiough cioss-iefeience to the Commouity Exchange Act ("CEA"). CEA
1a(4) uefines "commouity" to incluue agiicultuial piouucts "anu all othei goous
anu aiticles, except onions as pioviueu in section 1S-1 of this title, anu all seivices,
iights, anu inteiests in which contiacts foi futuie ue-liveiy aie piesently oi in the
futuie uealt in." The oiigins of the amusing "onion" exception aie uetaileu in
http:www.time.comtimemagazineaiticleu,9171,891S11,uu.html. Seveial
othei paits of Coue 761 also cioss iefeience the CEA. )"" 0lympic Natuial uas, 294
F.Su 7S7, 74u-41 (Sth Cii. 2uu2) ("The teim 'commouity contiact' 'encompasses
puichases anu sales of commouities foi futuie ueliveiy on, oi subject to the iules of,
a contiact maiket oi boaiu of tiaue . . . .' In contiast, 'foiwaiu contiacts' aie
'contiacts foi the futuie puichase oi sale of commouities that aie not subject to the
iules of a contiact maiket oi boaiu of tiaue.'").
27
Foiwaiu contiact is uefineu in 1u1(2S), to incluue contiacts (othei than
commouity contiacts, see /8#,$ note 26) foi the puichase, sale oi tiansfei of a
commouity at least two uays in the futuie, anu incluues "a iepuichase oi ieveise
iepuichase tiansaction . . . consignment, lease, swap, heuge tiansaction, ueposit,
loan, option, allocateu tiansaction, unallocateu tiansaction, oi any othei similai
agieement."
28
11 0.S.C. 1u1(47). A iepuichase agieement oi "iepo," is essentially the sale of a
financial instiument combineu with a foiwaiu contiact to iepuichase the same. The
initial "buyei" is compensateu by the "sellei" thiough a uiffeience between the
7

A piotecteu contiact, that is one that falls within one of the foiegoing categoiies, is
only piotecteu if the holuei is also a piotecteu peison, as uefineu in the Bankiuptcy
Coue. Financial paiticipants
Su
- essentially veiy laige financial institutions - aie
always piotecteu. Anu with iegaiu to each class of piotecteu ueiivative contiact
theie is also a moie specific class of piotecteu paities.
S1


In some cases these lattei categoiies have some ieal meaning. Foi example, foiwaiu
contiacts aie only subject to the safe haibois with iegaiu to financial paiticipants
anu "foiwaiu contiact meichants." A foiwaiu contiact meichant means eithei a
Feueial Reseive Bank oi an entity "whose business consists in whole oi in pait of
enteiing into foiwaiu contiacts."
S2
0n the othei hanu, the cuiient uefinitions of
"iepo paiticipant"
SS
anu "swap paiticipant"
S4
aie essentially vacuous, iequiiing
nothing moie than the peison in question be paity to a iepo oi swap with the
uebtoi. In shoit, anyone who is a paity to these soits of contiacts is apt to be a
piotecteu peison with iegaiu to these contiacts.

The safe haibois pioviue non-bankiupt counteipaities with the ability to exeicise
contiactual iights allowing liquiuation, teimination oi acceleiation of ueiivative
contiacts upon bankiuptcy,
SS
the iight to set off oi net ueiivative contiacts fiee of

initial payment anu the final payment. To qualify unuei the Coue's uefinition, the
iepuichase obligation must occui within one yeai, but the uefinition expiessly
excluues a iepuichase obligation involving a paiticipation in a commeicial moitgage
loan. Note, howevei, that these types of iepos might constitute anothei type of
piotecteu contiact, paiticulaily a swap oi secuiities contiact. )"" In ie Bamilton
Taft & Co., 114 F.Su 991 (9th Cii. 1997).
29
11 0.S.C. 1u1(SSB). The uefinition incluues not only obvious swaps, like CBS,
inteiest iate swaps, anu cuiiency swaps, but also any instiument "of a type that has
been, is piesently, oi in the futuie becomes, the subject of iecuiient uealings in the
swap maikets" incluuing "a foiwaiu, swap, futuie, option oi spot tiansaction on one
oi moie iates, cuiiencies, commouities, equity secuiities, oi othei equity
instiuments, uebt secuiities oi othei uebt instiuments, quantitative measuies
associateu with an occuiience, extent of an occuiience, oi contingency associateu
with a financial, commeicial, oi economic consequence, oi economic oi financial
inuices oi measuies of economic oi financial iisk oi value." In shoit, eveiy
conceivable ueiivative contiact.
Su
11 0.S.C. 1u1(22A) (uefining "financial paiticipant").
S1
With iegaiu to secuiities contiacts with the uebtoi, the counteipaity must be a
"stockbiokei," "financial institution," "financial paiticipant" oi "secuiities cleaiing
agency."
S2
11 0.S.C. 1u1(26). )"" $%/. In ie Niiant Coip., S1u B.R. S48, S68 (Banki. N.B. Tex.
2uu4).
SS
11 0.S.C. 1u1(46).
S4
11 0.S.C. 1u1(SSC).
SS
11 0.S.C. SSS (secuiities contiacts), SS6 (foiwaiu anu commouities contiacts)
8
the automatic stay,
S6
anu bioau immunity fiom avoiuance actions.
S7
These
piotections also extenu to ueiivative tiansactions nestleu unuei a mastei
agieement, even if the mastei agieement aggiegates uispaiate types of ueiivative
contiacts.
S8
Secuiity agieements anu othei cieuit enhancements aie also
encompasseu within the uefinitions of piotecteu contiacts, anu thus subject to the
safe haibois.
S9



-P <(" D,.-%"@$'29 <(".,"'29$% =.845$'2.4/ .* '(" )$*" +$,-.,/

Theie have been two tiauitional justifications foi the foiegoing safe haiboi
piovisions. Fiist, the piovisions aie saiu to piohibit unfaii "cheiiy picking" of

SS9 (iepuichase oi "iepo" agieements), S6u (swaps). The exceptions apply to a
"contiactual iight," which incluues iights pioviueu foi in a iule by vaiious tiaue
oiganizations oi exchanges.
S6
11 0.S.C. S62(b)(6) (secuiities contiacts, foiwaius anu commouity contiacts),
S62(b)(7) (iepos), S62(b)(17) (swaps). )"" $%/. 11 0.S.C. S62(o) (exeicise of
iights unuei the foigoing piovisions not subject to any stays), SS6 (foiwaius anu
commouity contiacts piotecteu paities' iight to maigin payments unuei those
contiacts shall not be stayeu, avoiueu oi limiteu), S6u (unuei a swap iight to offset
oi net-out any teimination values oi payment amounts shall not be stayeu, avoiueu
oi limiteu).
S7
11 0.S.C. S46(e), (f), (g), (j), S48(u)(2)(B), (C), (B). The foiegoing sections of
section S46 piohibit the biinging of avoiuance actions unuei sections S44, S4S, S47,
S48 (a)(1)(B), anu S48 (b) of the Bankiuptcy Coue. The foiegoing piovisions of
section S48 pioviue that a ueiivatives counteipaity always takes foi value,
potentially complicating an attempt to iecovei a tiansfei as an actual fiauuulent
tiansfei. 11 0.S.C. S48(c). This authoi is at a loss to explain how a ueiivative might
be a statutoiy lien unuei section S4S. These piovisions uo not seem to piohibit the
lifting of the automatic stay to allow a cieuitoi to biing an avoiuance action unuei
state oi feueial non-bankiuptcy law, so long as the cieuitoi uiu not biing such
action on behalf of the estate. ?*. 11 0.S.C. S44(b)(1).
S8
11 0.S.C. S62(b)(27) (allows setoffs anu netting unuei mastei netting
agieements) S61 (iight to teiminate, acceleiate oi liquiuate, oi to offset, oi net
teimination values, payment amounts oi othei tiansfei obligations aiising unuei oi
in connection with one oi moie secuiities contiacts, commouity contiacts, foiwaiu
contiacts, iepuichase agieements, swap agieements oi mastei netting agieements,
shall not be stayeu, avoiueu oi limiteu by opeiation of the bankiuptcy coue oi by
oiuei of a couit oi auministiative agency). )"" $%/. 11 0.S.C. 1u1(S8A) (uefinition
of "mastei netting agieement"). The uefinitions of secuiities contiacts,
commouities, foiwaiu contiacts, iepuichase agieements, anu swap agieements
also incluue "a mastei agieement" that incluues the uefineu contiacts. Note the
slight uiffeience in teiminology between "mastei agieement" anu "mastei netting
agieement."
S9
)""0 "PBP0 11 0.S.C. 1u1(2S)(E) (uefinition of "foiwaiu contiact").
9
contiacts by uebtois.
4u
Anu seconu, the safe haibois aie saiu to ieuuce systemic
iisk, that is, the iisk system-wiue ciisis iesulting fiom a bankiuptcy case.
41


In paiticulai, the safe haibois as cuiiently enacteu weie piomoteu by the
ueiivatives inuustiy as necessaiy measuies to suppoit "close out netting."
42
Close
out netting is, in shoit, a technical teim foi enfoicement of 2#/. *$9'. (i.e.,
bankiuptcy teimination) clauses anu setoff of the iesulting mass of claims iesulting
fiom the teiminateu ueiivative contiacts.
4S
Accoiuing to the financial community,
only with close out netting coulu cheiiy picking anu systemic iisk be avoiueu.

The cheiiy picking aigument iests on the belief that it is somehow inequitable foi a
uebtoi to ietain favoiable ueiivatives while iejecting unfavoiable contiacts.
44
0f
couise, this ability to ueciue whethei to tieat a contiact as an asset oi a uebt is key
to the opeiation of section S6S, anu applies to all soits of contiacts.
4S
It thus
imposes no special buiuen on ueiivative contiacts.
46
Noieovei, the safe haibois
simply give the non-uebtoi paity an option to teiminate upon a bankiuptcy - which
amounts to cheiiy picking fiom the othei siue of the ueal.
47



4u
)"" In ie Enion, Inc., S49 B.R. 96, 1u6 (Banki. S.B.N.Y. 2uu6).
41
)"" Steven L. Schwaicz, ):/'"@29 !2/7, 97 ueo. L.}. 19S, 196-2u4 (2uu8) (uefining
systemic iisk as: "the iisk that (i) an economic shock such as maiket oi institutional
failuie tiiggeis (thiough a panic oi otheiwise) eithei (X) the failuie of a chain of
maikets oi institutions oi (Y) a chain of significant losses to financial institutions,
(ii) iesulting in incieases in the cost of capital oi uecieases in its availability, often
eviuenceu by substantial financial-maiket piice volatility").
42
The Piesiuent's Woiking uioup on Financial Naiket, +"5B" =845/0 E"3",$B"0 $45
'(" E"//.4/ .* E.4BI<",@ ?$#2'$% J$4$B"@"4' (1999); B.R. Rep. No. 1u9-S1(I), at S,
2u, 1S1-S2 (2uuS), iepiinteu in 2uuS 0.S.C.C.A.N. 88, 89, 1uS-u6, 191-92.
4S
The safe haiboi piovisions peimit qualifying non-uebtoi counteipaities to
liquiuate, teiminate oi acceleiate contiacts anu net out positions. All othei 2#/.
*$9'. piovisions iemain unenfoiceable unuei the Bankiuptcy Coue. )"" In ie
Lehman Bios. Boluings Inc., 416 B.R. S92 (Banki. S.B.N.Y. 2uu9).
44
Auam R. Waluman, H<? 1",23$'23"/ Y ):/'"@29 !2/7; K44.3$'23" =24$49" H, <("
1$49" K4'. <(" F-://U, 4S Am. 0. L. Rev. 1u2S, 1uS9-6u (1994).
4S
Lubben, /8#,$ note 2.
46
Although iaiely maue, one aigument that might suppoit the safe haibois oi at
least some special tieatment of ueiivatives in bankiuptcy tuins on the "zeio sum"
natuie of ueiivative contiacts. While most contiacts can have value to both paities,
most ueiivatives aie only valuable to the uebtoi in situations wheie they aie not
valuable to the non-uebtoi, anu vice-veisa.
47
The safe haibois give the non-uebtoi the option to teiminate, but uo not iequiie
it, anu thus cieate a kinu of assumption anu iejection powei on behalf of the non-
uebtoi. }onathon Keath Bance, 1",23$'23"/ $' 6$47,8#'9:; E2*"/$324B T4.>%"5B" *.,
'(" )@$%% =2,@, 6S Wash. & Lee L. Rev. 711, 7S6 (2uu8).
1u
The systemic iisk aigument foi the safe haibois is baseu on the belief that the
inability to close out a ueiivative position because of the automatic stay woulu cause
a uaisy chain of failuie amongst financial institutions.
48
The pioblem with this
aigument is that it fails to consiuei the iisks cieateu by the iush to close out
positions anu uemanu collateial fiom uistiesseu fiims.
49
Not only uoes this
contiibute to the failuie of an alieauy weakeneu financial fiim, by fosteiing a iun on
the fiim, but it also has consequent effects on the maikets geneially, as paities iush
to sell tiaues with the uebtoi anu buy coiiesponuing positions with new
counteipaities.
Su
It is not cleai that this lattei uisiuption, cieateu by the safe haiboi
exceptions to the automatic stay anu the uebtoi's avoiuance poweis,
S1
is not
systemically moie impoitant than the iisk that is put foith in suppoit of the safe
haibois, paiticulaily if one consiueis that the automatic stay can always be lifteu by
the bankiuptcy couit.
S2
Anu while it is sometimes saiu that iepealing the safe
haibois will simply move the iun on the uebtoi to the pie-bankiuptcy peiiou, this
neglects the effect of the uebtoi's ability to biing a piefeience action.
SS
0nless the
non-uebtoi counteipaity plans theii iun 9u uays in auvance - anu can convince the
uebtoi not to file uuiing the inteiim - this aigument uoes not seem plausible.
S4


Inueeu, the cuiient safe haibois woulu seem to be the souice of consiueiable ueau
weight anu systemic losses. These losses effect both the bankiuptcy estate uiiectly
anu laigei questions of societal wealth.


48
It is also sometimes suggesteu that the meie act of a financial fiim's bankiuptcy
filing cieates systemic iisk, but that seems to confuse the piocess of bankiuptcy
with the geneial ieality of uefault. }ean Belwege, =24$492$% =2,@ 6$47,8#'9: $45
):/'"@29 !2/7, 2u }. Int'l Fin. Naikets, Institutions & Noney, Feb. 2u1u, at 1, 2
(aiguing that bankiuptcies of financial fiims "aie symptomatic of common factois in
poitfolios that leau to wealth losses iegaiuless of whethei any paiticulai fiim files
foi bankiuptcy").
49
Lubben, /8#,$ note 1.
Su
http:online.wsj.comaiticleSB12SuSu91677uuS8267.html
S1
Foi example, the knowleuge that the uebtoi will be unable to biing a piefeience
action ielateu to a ueiivative contiact iemoves any incentive to iefiain fiom
uemanuing collateial on the eve of bankiuptcy.
S2
11 0.S.C. S62(u). uiven the numbeis of contiacts involveu in the chaptei 11 case
of a laige financial institution, it may be that the bankiuptcy couit woulu have to
iule on entiie classes of ueiivatives, absent unique facts iegaiuing a specific
tiansaction that might waiiant lifting the stay.
SS
11 0.S.C. S47.
S4
?*P In ie Enion Cieuitois Recoveiy Coip., 422 B.R. 42S (S.B.N.Y. 2uu9) (non-
oiuinaiy couise teimination of commeicial papei on eve of bankiuptcy not
avoiuable because of safe haiboi piovisions).
11
93:*)# H< !0,&L M#,*)' 4N&+ !)&'8&-,30'


Foi example, imagine Lehman Biotheis has inteimeuiateu a total-ietuin swap on a
million shaies of B0uARTC0 stock
SS
wheie Paity A ieceives anu Lehman pays the
B0uARTC0 ietuin. B0uARTC0 shaies aie cuiiently tiauing at $4u. At the same
time, Paity B pays the ietuin of B0uARTC0 anu Lehman ieceives the ietuin of
B0uARTC0 foi some peiiou of time, with Lehman eaining a ietuin on the uiffeience
oi spieau between the two vaiiable inteiest iate legs of these tiansactions.

When Lehman enteis bankiuptcy, this tiansaction is an asset of the estate, because
it eains a valuable ietuin foi Lehman. But that asset is uestioyeu unuei the safe
haibois, which peimit anu encouiage teimination of the ueal. Noieovei, when
Paity A teiminates its ueal with Lehman unuei the safe haibois anu has to ieplace
his long swap on the million shaies, imagine he senus his teimination notice the uay
Lehman files anu buys the one million shaies--his buying pushes the stock piice up
fiom 4u to 42 uollais anu he pays, on aveiage, 41 foi his new shaies.

Paity B is in Asia anu it takes hei a few auuitional uays to act, anu hei teimination
notice goes out a week latei. She then ieestablishes hei position, which is shoit
B0uARTC0, anu sells hei B0uARTC0 shaies anu pushes the piice fiom 4u to S8

SS
As my stuuents well know, B0uARTC0 is the leauing hypothetical manufactuiei
of tienchcoats anu feuoias. )"" Lubben, /8#,$ note 2.
12
with aveiage of S9. Each paity then files a pioof of claim foi $1 million, theii
iespective loses, foi a total of $2 million against the estate. This amount plus the
loss to Lehman is the total wealth uestioyeu by the safe haibois.

It seems cleai that it woulu both ieuuce systemic iisk anu enhance the ietuin to the
uebtoi's cieuitois to uispose of a financial fiim's ueiivative poitfolio as a whole,
peihaps as pait of a quick S6S sale of the uebtoi's entiie business, iathei than see
it uismembeieu in a panic in the sales befoie anu immeuiately aftei a chaptei 11
filing. In shoit, the safe haibois woulu seem to piomote the piematuie liquiuation
of a uebtoi, with bau effects foi the laigei financial maikets. Knowing that the safe
haibois aie in place, potential uebtois with laige ueiivative positions aie
encouiageu to avoiu chaptei 11 foi as long as possible, meaning that when they uo
finally entei bankiuptcy they aie likely to have uissipateu theii woiking capital anu
ieacheu a point of extieme illiquiuity.

The systemic iisk justification foi the safe haibois also uoes nothing to explain why
they apply to all uebtois, no mattei how systemically unimpoitant.

Because the safe haibois seem to lack goou justifications, anu aie at the veiy least
oveibioau, I have aigueu that they shoulu be iepealeu oi uiastically amenueu. The
iemainuei of this papei examines the issues that aiise fiom such a iepeal.


II. Beiivatives anu the Bankiuptcy Coue

uiven that the bioau justifications foi the safe haibois have been founu wanting,
this section examines the issues that aiise fiom the inteiaction of ueiivatives with
chaptei 11 specifically anu the Bankiuptcy Coue geneially. The goal heie is to
uevelop a list of the ieal issues that meiit attention, a list that will uiive the
uiscussion of possible changes to the Coue set foith in Pait III.

Initially, consiuei a specific instance wheie the "cheiiy picking" aigument might be
moie peisuasive. It is sometimes saiu that the safe haibois have a special salience
with iegaiu to centially cleaieu ueiivative contiacts, like commouity futuies. In
paiticulai, because a cential cleaiing agency is exposeu to counteipaity cieuit iisk
fiom each of its paiticipants, the safe haibois aie saiu to ieuuce the iisk that the
cential agency might fail. Anu it is tiue that the eaily safe haibois weie only
applicable to centially cleaieu ueiivatives, a point Congiess seems to have foigotten
as it expanueu the safe haibois to 0TC tiansactions.

Neveitheless, it is not cleai that safe haibois pioviue any ieal systemic piotection
even in this context. Cential cleaiing of ueiivatives has been piomoteu since the
financial ciisis as a tool foi ieuucing systemic iisk, as the cential cleaiing agency can
use its position in the hub as a monitoi of the exposuie of the paities it tiaues with
1S
anu pioviue infoimation to iegulatois about maiket in geneial.
S6
Systemic iisk is
ieuuceu by foicing a laige volume of tiaues to be cential cleaieu, anu then iequiiing
membeis in the cleaiing oiganization to post collateial anu entei into obligations to
funu the cential agency in times of ciisis, when the collateial oi maigin accounts
may not pioviue sufficient liquiuity. Safe haibois woulu seem to unueimine this
stiuctuie by uulling the cential agency's incentives to monitoi its membeis - the
centially cleaiing agency must have some uegiee of counteipaity iisk, so that it has
incentives to use its position to ieuuce oveiall systemic iisk. Safe haibois that allow
the cential cleaiing paity to iemove itself fiom the miuule of tiaues aie uiiectly
contiaiy to the goals of incieaseu cential cleaiing.

A moie substantial set of conceins involves the peiiou of time between the uebtoi's
bankiuptcy filing anu its uecision to assume oi ieject a paiticulai ueiivative.
S7
Foi
example, consiuei an "in the money" call option that expiies a week aftei the
petition uate.
S8
The non-uebtoi counteipaity will have legitimate conceins about
the uebtoi's willingness to peifoim anu its ability to uo so without couit
authoiization.
S9
Anu if the non-uebtoi paity has to seek a couit oiuei to compel the
uebtoi's peifoimance oi authoiize the same, the stiike piice of the call has
effectively been incieaseu by the amount of the legal fees incuiieu. While these
conceins aie somewhat tiue of all contiactual counteipaities, they seem likely to
aiise with gieatei fiequency with iespect to ueiivative tiansactions, given the
ielatively shoit uuiations anu sheei numbei of contiacts that might be involveu,
anu uebtoi "stonewalling" is apt to have giavei consequences.

Similaily, although ueiivative tiansactions aie incieasingly secuieu by posteu
collateial, these tiansactions aie unlike most othei secuieu uebts in that the values
at stake change uaily, anu often change quite uiamatically. This volatility is likely to
be exaceibateu by the chaptei 11 filing of a laige uealei. The Coue iecognizes the
iights of a secuieu cieuitoi to "auequate piotection" while they aie stayeu fiom
iealizing on theii collateial,
6u
but its stiuctuie uoes not anticipate the possibility of a
claim that might change in value on a uaily oi houily basis.

Inueeu, the Bankiuptcy Coue is uesigneu to auuiess collateial value fluctuations, not
claim value fluctuations, which is what is ieally at issue with iegaiu to ueiivatives.
The Coue was uesigneu with a fixeu loan obligation in minu, anu the concein was
that the collateial suppoiting that loan might ueteiioiate uuiing the uelay causeu by
the bankiuptcy case. The collateial posteu in a ueiivative tiansaction is often cash

S6
http:www.ft.comcmssue81cS2cu-uu77-11uf-bSub-uu144feabucu.html
S7
11 0.S.C. S6S(u)(2) ("In a case unuei chaptei 9, 11, 12, oi 1S of this title, the
tiustee may assume oi ieject an executoiy contiact oi unexpiieu lease of iesiuential
ieal piopeity oi of peisonal piopeity of the uebtoi at any time befoie the
confiimation of a plan . . .").
S8
That is, an option to buy an asset at a piice less than the cuiient maiket piice.
S9
11 0.S.C. S6S(c)(1).
6u
11 0.S.C. S61.
14
oi high quality secuiities, anu thus not especially likely to uecline in value, but the
uebtoi's potential liability on the ueiivative instiument changes iapiuly. The Coue
expiessly iecognizes that a ueiivative contiact might be valueu post-petition to
calculate iejection uamages,
61
but it uoes nothing to solve the ielateu auequate
piotection pioblem.
62
This iepiesents a key issue to be auuiesseu upon iepeal of
the safe haibois.

The ueiivatives community's inteiest in safe haibois is tieu to the belief in the
benefits of close out netting, which involves the teimination of all ueiivatives with a
paiticulai uebtoi anu the setting off of settlement payments oweu unuei those
contiacts. 0f couise, if the safe haibois aie iepealeu, theie will be fewei contiacts
teiminateu. But theie iemains a possibility that many setoff situations will aiise
nonetheless, as the uebtoi iejects unfavoiable ueiivative tiaues but the
counteipaity ueuucts the bieach uamages fiom payments oweu to the uebtoi on
othei tiaues that the uebtoi assumes.

0ne potential pioblem foi futuie setoffs is the geneial iule that a setoff is not
appiopiiately effectuateu against two uiffeient uebtois, even if those uebtois aie
pait of a single coipoiate enteipiise.
6S
Thus, a heuge funu who enteis into a put
option on a paiticulai company's shaies with Bebtoi Biokeiage, Inc. anu a total
ietuin swap on the same shaies with Bebtoi Special Financing, Inc. is unable to
offset these two positions in bankiuptcy, even though they likely weie uesigneu as a
single tiaue on the unueilying shaies. This pioblem is fuithei exaceibateu in cases
like Lehman Biotheis, wheie the uebtoi entities might have bankiuptcy cases
penuing in uiffeient countiies.
64


But it is not cleai that this pioblem neeus oi waiiants a bankiuptcy solution.
6S

Insteau, the easy answei is foi laigei ueiivatives uealeis to conuuct all of theii
tiaues thiough a single subsiuiaiy, giving counteipaities the comfoit that theii
setoff iights will be pieseiveu if the woist happens.


61
Although the cases aie split on the issue, many couits holu that bieach claims on
tiauitional contiacts aie "as of" the petition uate.
62
11 0.S.C. S62.
6S
In ie SemCiuue, L.P., S99 B.R. S88 (Banki. B. Bel. 2uu9). 68' /"" Naitin }.
Bienenstock et al., F," <,2$4B8%$, )"'.** FB,""@"4'/ G4*.,9"$-%" 24 6$47,8#'9:U0 8S
Am. Banki. L.}. S2S (2uu9) (aiguing that )"@?,85" was wiongly ueciueu).
64
Although the uevelopment of "iesolution authoiity" to hanule the collapse of
financial institutions is beyonu the scope of this aiticle, this suggests a neeu to
cooiuinate such authoiity acioss the key financial juiisuictions - at the veiy least,
New Yoik anu Lonuon neeu to be integiateu in this iegaiu.
6S
)"" In ie Bevill, Bieslei & Schulman Asset Ngmt. Coip., 896 F.2u S4, S7 (Su Cii.
199u) ("setoff is at ouus with a funuamental policy of bankiuptcy, equality among
cieuitois ...").
1S
Avoiuance actions aie also an obvious concein foi the ueiivatives inuustiy,
inasmuch as a fiauuulent tiansfei oi piefeience action has the potential to "unuo" a
seemingly complete anu settleu tiansaction.
66
But many stateu conceins about
avoiuance actions appeai to be inflateu, once closely examineu. Foi example, most
common ueiivative opeiations woulu seem to be piotecteu against piefeience
attack by the Coue's "oiuinaiy couise of business" uefense, which piotects
tiansactions that aie iegulai eithei as to the paities oi the ielevant inuustiy.
67


0n the othei hanu, a paity that attempts to foice an eaily exit, without eithei
contiactual iight oi inuustiy piactice to back it up, shoulu face an avoiuance
action.
68
Anu the Coue will have to guaiu against attempts to giab massive amounts
of collateial on the eve of bankiuptcy, in a way that is unielateu to the unueilying
value of the tiaues being collateializeu. Foi example, incieaseu collateial posting
obligations that aie tieu to the uebtoi's cieuit iating shoulu not be ueemeu oiuinaiy
couise, as I uiscuss in gieatei uetail in the next pait of the papei.

It is conceivable, howevei, that pie-bankiuptcy auheience to ceitain ueiivative
teims might leau to a viable claim of fiauuulent tiansfei. Foi example, some
ueiivatives contain "walk-away" piovisions that pioviue that a bieaching paity -
anu filing a chaptei 11 petition constitutes a bieach - is not entitleu to any payment
upon teimination of the ueiivative.
69
To the extent this non-bieaching paity ietains
value that is gieatei than its uamages, theie is an aigument to be maue that this
constitutes a tiansfei of the uebtoi's piopeity foi less than ieasonability equivalent
value, anu is thus avoiuable.
7u
0n the othei hanu, if the non-uebtoi can point to
some value given at the inception of the tiansaction, then the tiansaction is not
avoiuable.
71
In shoit, it is not cleai that theie is a ieal pioblem heie, anu fiom a

66
Stephen }. Lubben, 6":.45 <,8" )$%"/; )"98,2'Z$'2.4 $45 ?($#'", CC, 1 N.Y.0.}.L. &
Bus. 89, 1u7 (2uu4).
67
11 0.S.C. S47(c)(2).
68
)"" In ie Enion Cieuitois Recoveiy Coip., 422 B.R. 42S (S.B.N.Y. 2uu9) (non-
oiuinaiy couise teimination of commeicial papei on eve of bankiuptcy not
avoiuable because of safe haiboi piovisions).
69
The enfoiceability of "walk-away" piovisions is piesently being litigateu in the
context of seveial auveisaiy pioceeuings in the Lehman Biotheis Boluings Inc. anu
Lehman Biotheis Special Financing Inc. bankiuptcy pioceeuings. )"" "PBP0 Lehman
Biotheis Special Financing Inc. v. Baiiiei Finance Ltu. (In ie Lehman Biotheis
Boluings Inc.), Ch. 11 Case No. u8-1SSSS, Auv. No. u9-u1241 (Banki. S.B.N.Y. 2uu9)
(iegaiuing the enfoiceability of a cieuit uefault swap "walk-away" piovision). Some
of the auveisaiy cases have been settleu without a uecision. 68' /"" Biexel
Buinham Lambeit Pious. Coip. v. Niulanu Bank PLC, 1992 0.S. Bist. LEXIS 2122S
(S.B.N.Y. Nov. 9, 1992) (similai piovision founu enfoiceable).
7u
11 0.S.C. S48(a)(1)(B).
71
Nellon Bank, N.A. v. Netio Comm'cns, Inc., 94S F.2u 6SS, 647 (Su Cii. 1991). In
the context of CB0s, iatings agencies often uemanueu these piovisions to piotect
the special puipose entity fiom incuiiing a laige payment obligation.
16
policy peispective it seems uoubtful the Bankiuptcy Coue shoulu go out of its way to
accommouate a contiactual teim that seems uelibeiately uesigneu to stiip assets
fiom the estate.
72


0f couise, even if theie is no legal basis foi an avoiuance action, counteipaities still
have to woiiy about a suit biought to inuuce a settlement. This is paiticulaily tiue
as an incieasing numbei of chaptei 11 plans aie offeiing unsecuieu cieuitois a
iecoveiy that is contingent on the iesults of litigation. Thus avoiuance actions,
while not a piimaiy concein, uo piesent some ieal iisk to the ueiivatives maikets in
the foim of unceitainty.

Finally, the inteiaction of chaptei 11 with the iepo maikets neeus to be auuiesseu.
But fiist, we neeu to consiuei the bioau iange of tiansactions that come unuei the
heauing of "iepuichase agieements."

A tiauitional iepo agieement involves the sale of a high-quality asset, often Tieasuiy
oi othei goveinment papei, oi highly iateu bonus, with an agieement to iepuichase
the same in the veiy neai teim, often the next uay.
7S
The spieau between the sale
anu puichase piice amounts to inteiest, anu the iates on oveinight iepos aie usually
quite close to iates on oveinight loans in the feueial funus maiket. In auuition to
chaiging inteiest, the lenueipuichasei in a iepo tiansaction typically only pioviues
cash equal to a fiaction of the collateial value "solu" in the tiansaction - which
pioviues an extia maigin of piotection in case of uefault.
74


These tiauitional iepos play an impoitant iole in the functioning of financial
maikets.
7S
They aie wiuely useu by secuiities uealeis anu they pioviue a way foi
mutual funus, uepositoiy institutions, anu otheis to eain a ietuin on funus that aie
above the ueposit insuiance limits foi tiauitional bank accounts. Repos aie also
fiequently useu in open maiket opeiations by the Feueial Reseive, since they
pioviue a convenient way to auu oi subtiact cash ieseives fiom the financial
system.
76


72
12 0.S.C. 1821(e)(8)(u) ("walk-away" piovisions unenfoiceable unuei the
Feueial Beposit Insuiance Act).
7S
Stephen A. Lumpkin, !"#8,9($/" $45 !"3",/" !"#8,9($/" FB,""@"4'/, in TIN0TBY
Q. C00K ANB R0BERT K. LAR0CBE EBS., INSTR0NENTS 0F TBE N0NEY NARKET ch. 6 (199S).
74
This uiscount oi "haiicut" was extiemely small befoie 2uu7, but began to giow,
paiticulaily foi housing-ielateu assets, as counteipaities began to uoubt theii
ability to piopeily value the assets. 0bviously the giowth of these haiicuts can
cieate a liquiuity ciunch foi an institution that is heavily ieliant on the ability to
boiiow against moitgage-backeu secuiities to finance uaily opeiations. )"" uaiy
uoiton0 [8"/'2.4/ $45 F4/>",/ F-.8' '(" =24$492$% ?,2/2/, 12-1S (2uu9)
(http:www.fcic.govuay2uoiton.puf).
7S
)"" Kenneth C. Ketteiing, )"98,2'2Z$'2.4 $45 K'/ 12/9.4'"4'/; <(" 1:4$@29/ .*
=24$492$% D,.589' 1"3"%.#@"4', 29 Caiuozo L. Rev. 1SSS, 164u-4S (2uu8).
76
http:www.newyoikfeu.oigaboutthefeufeupointfeuu4.html.
17

The iepo maiket as thus uesciibeu plays an impoitant iole in the financial system
that neeus to be piotecteu. Noieovei, because of the exceeuingly small maigins
involveu in these tiaues, imposition of bankiuptcy costs on the maiket might have
seiious untowaiu consequences. Accoiuingly, this is an issue to be auuiesseu if the
safe haibois aie iepealeu.
77


But in the past uecaue, the iepo maiket has expanueu fai beyonu its tiauitional
ioots. Fiist, investment banks became highly ieliant on iepo tiansactions to pioviue
funuing, anu incieasingly these iepo tiansactions weie conuucteu with moitgage-
backeu secuiities.
78
The high iatings these secuiities ieceiveu fiom the iating
agencies, combineu with the favoiable tieatment of iepos unuei the Bankiuptcy
Coue, may have encouiageu excessive use of this type of financing by convincing the
iecipients of these secuiities that they weie just as goou of collateial as that useu in
"olu fashioneu" iepo aiiangements.
79


Noie impoitantly, in a move that seems extiemely inoppoitune in hinusight, the
2uuS Amenuments to the Bankiuptcy Coue bioaueneu the uefinition of a
"iepuichase agieement," pieviously limiteu to obligations of the 0niteu States anu
othei highly iateu secuiities, to incluue moitgage loans anu inteiests in moitgage
loans. In auuition to facilitating oi, moie likely, acknowleuging, the substantial
expansion of shoit-teim iepo financing alieauy uesciibeu, this change hau at least
two othei effects that may have contiibuteu to the financial ciisis.

Fiist, the tiauitional "waiehouse loan" useu by moitgage oiiginatois was
tiansfoimeu into a iepo agieement that ieceiveu the piotections of the safe
haibois.
8u
Tiauitional waiehouse loans weie shoit-teim loans secuieu by
moitgages iecently oiiginateu. The loan pioviueu the oiiginatoi with liquiuity until
enough moitgages hau been oiiginateu to foim the basis foi a secuiitization. Post
2uuS, waiehouse financing aiiangements typically have been uocumenteu as
"mastei iepuichase agieements" unuei which an oiiginatoi sells moitgage loans to
its foimei lenuei with a simultaneous agieement by the oiiginatoi to iepuichase

77
I appioach this fiom a bankiuptcy peispective. It is, of couise, quite possible that
the size anu extensive ieliance on the iepo maiket, even in its tiauitional foim,
iepiesent a systemic iisk pioblem in neeu of a iegulatoiy solution. But that solution
woulu not occui thiough the Bankiuptcy Coue.
78
Clauuio E. Rauuatz, O("4 '(" !23",/ !84 1,:; E2\8252': $45 '(" ]/" .* O(.%"/$%"
=845/ 24 '(" <,$4/@2//2.4 .* '(" ]P)P )8-#,2@" ?,2/2/ (Febiuaiy 1, 2u1u). Woilu Bank
Policy Reseaich Woiking Papei Seiies, vol. , pp. -, 2u1u. Available at SSRN:
http:ssin.comabstiact=1SS972u.
79
Although uata on the total size of the iepo maiket is limiteu, it is often saiu to have
been in the $1u to $12 tiillion iange in eaily 2uu7.
8u
Thomas E. Plank, <.>$,5 $ J.," G**292"4' 6$47,8#'9: E$>; J.,'B$B" =24$4924B
]45", '(" VRR^ 6$47,8#'9: F@"45@"4'/, S1 S. Ill. 0. L.}. 641, 666-67 (2uu7) (lauuing
this uevelopment).
18
fiom the lenuei. The iepuichase is then consummateu when the secuiitization
happens.

The economic effect of the ueal is the same, but now the lenuei no longei has to
woiiy about becoming involveu in a bankiuptcy pioceeuing. This may have
encouiageu excessive lenuing to moitgage oiiginatois.

93:*)# O< =4/D /0'1*3, 4,)*-,*)#


Peihaps moie impoitantly, following the 2uuS Amenuments, iepuichase
agieements became much moie common in asset-backeu commeicial papei (ABCP)
conuuits anu stiuctuieu investment vehicles (SIvs), the financial stiuctuies that
weie amongst the fiist to collapse in the financial ciisis.
81
At heait, an ABCP facility
is a means of secuiitizing lowei quality assets in a way that will allow the oiiginatoi
oi buyei of these assets to issue highly iateu money maiket instiuments,
tiauitionally among the cheapest foim of coipoiate finance available.
82
Banks anu

81
Befaults in this maiket began to occui moie than a yeai befoie the Lehman
bankiuptcy. http:mba.yale.euunews_eventspuffinancial%2uconf-
papei%2u19.puf
82
Fiank Paitnoy, )($#"/(2*'24B ?.,#.,$'2.4/, 76 0. Chi. L. Rev. 261, 268-69 (2uu9)
("An SIv is sometimes calleu a "conuuit" because it iaises shoit-teim funus anu
channels those funus into longei-teim assets. An SIv's business mouel iesembles
19
similai lenueis founu conuuits anu SIvs attiactive because they alloweu them to
continue to offei tiauitional ieceivables financing without the iegulatoiy
implications of making a loan that woulu appeai on theii balance sheet.
8S


These off-balance-sheet vehicles weie thus holueis of long-teim assets financeu
using shoit-teim papei. This piesenteu an obvious pioblem, since theie aie
histoiical examples of peiious when commeicial papei woulu not "ioll," such as
aftei the Penn Cential bankiuptcy filing in 197u.
84
To oveicome this pioblem, the
sponsoiing bank gianteu a cieuit line, oi "liquiuity backstop," to the conuuit.
8S


Noieovei, aftei the 2uuS amenuments to the Coue, which weie accompanieu by
coiiesponuing amenuments to the ielevant banking statutes,
86
sponsoiing financial
institutions incieasingly useu iepo agieements to inciease the cieuit iating of the
ABCP issueu by conuuits anu SIvs. If a iepuichase agieement pioviueu foi full
iecouise to a highly iateu sponsoi - that is the ability to ietuin all the assets
87
- the
ABCP coulu be iateu baseu on the cieuit iating of the sponsoi, which seemeu to
iemove any neeu to ieflect on the quality of the unueilying assets being placeu in
the conuuit - anu thus the ability to tuin leau into golu, oi so it seemeu.
88



that of a bank: it seeks to eain a spieau between the inteiest iate at which it
boiiows anu the inteiest iate at which it lenus.").
8S
Tiaue ieceivables, auto loan tiansactions, anu cieuit caiu ieceivables weie the
most common assets useu in multi-sellei facilities - that is, facilities wheie the
sponsoi uiu not geneiate the assets. Sellei facilities - wheie the sponsoi geneiateu
the assets - often involveu cieuit caiu ieceivables anu moitgages.
84
http:www.time.comtimemagazineaiticleu,9171,878S74,uu.html ("0ntil the
collapse of the Penn Cential, commeicial papei was the nation's fastest-giowing
type of cieuit, but now it has become a piime souice of financial woiiy.").
8S
Aithui E. Wilmaith, <(" 1$,7 )25" .* ]423",/$% 6$4724B; =24$492$% ?.4B%.@",$'"/
$45 '(" H,2B24/ .* '(" )8-#,2@" =24$492$% ?,2/2/, 41 Conn. L. Rev. 96S, 1uSS-S4
(2uu9).
86
12 0.S.C. 1821(e)(8).
87
Conuuits enteieu into ieveise iepo agieements with sponsois unuei which the
sponsoi solu assets to the conuuit. 0n the matuiity uate of the iepo, if the conuuit
was unable to ioll (i.e., iefinance) the ABCP the iepo counteipaity was then
iequiieu to iepuichase the assets at the agieeu upon piice, anu the conuuit woulu
use the pioceeus to iepay matuiing ABCP anu the facility woulu come to an enu.
The safe haibois gave investois anu iating agencies comfoit that the assets coulu be
solu if the sponsoi expeiienceu financial uistiess - an assumption that iesteu on a
faith in the ability to sell the unueilying assets. )"" Caiiick Nollenkamp & Naigot
Patiick, ?,"52' ?,849(; ?2'2B,.8# J.3"/ '. [8"%% )KN ?.49",4/, Wall St. }., Sept. 7, 2uu7,
at C2.
88
)"" viial v. Achaiya et al., )"98,2'2Z$'2.4 O2'(.8' !2/7 <,$4/*",, NBER Woiking
Papei 1S7Su (2u1u) (available at http:www.nbei.oigpapeisw1S7Su).
2u
These lattei extensions of iepo agieements aie obviously unueseiving of too much
concein, anu thus when consiueiing how the Bankiuptcy Coue might accommouate
this maiket aftei iepeal of the safe haibois, it becomes impoitant to uistinguish
among the vaiious facets.

In shoit, following the iepeal of the safe haibois in the Coue, theie aie seveial key
aieas that neeu to be auuiesseu. Auequate piotection iules in the Coue aie ill
equippeu to hanule ueiivatives. This coulu leau to pioblems if the uebtoi is given an
extenueu peiiou of time to ueciueu whethei to assume oi ieject financial contiacts.
Tiauitional iepo agieements peifoim useful functions in the financial system that
may be limiteu if the safe haibois aie iepealeu anu avoiuance actions, paiticulaily
piefeience actions, coulu benefit fiom some auueu claiity. I auuiess each of these
issues in gieatei uetail in the next pait of this aiticle, but the list of issues uoes
illustiate the substantial oveibieauth of the existing safe haiboi piovisions, which
covei essentially the entiie ueiivatives maikets.


III. Accommouating the Reality of Beiivatives

In this section I suggest specific amenuments to the Coue that shoulu accompany
any iepeal of the safe haibois. But even this may be too naiiow, inasmuch as the
issue of safe haibois is closely tieu to the uebates ovei the natuie of the "iesolution
authoiity" to unwinu a faileu financial fiim. Foi example, while I uiscuss placing
limits on the uebtoi's time to assume oi ieject a ueiivatives contiact, plainly such
limits neeu to be integiateu with the time pioviueu foi the ieoiganization,
iecapitalization, oi sale of the uebtoi. Recognizing that this papei is just a piece of
an oveiall puzzle, I pioceeu.

$P F5"\8$'" D,.'"9'2.4

As noteu in Pait II, a key pioblem piesenteu by the cuiient Bankiuptcy Coue when
applieu to ueiivatives is that the Coue is uesigneu to auuiess compaiatively stable
claim values in the face of ueclining collateial values, but not the conveise. This
tiauitional unueistanuing of auequate piotection is iooteu in situations wheie the
non-uebtoi paity's obligations aie essentially complete anu non-executoiy, anu is of
little use in the context of an ongoing, bilateial ielationship.

In the ueiivatives context, I aigue that auequate piotection shoulu be
conceptualizeu on a piopoitionate basis: the non-uebtoi counteipaity shoulu be
piotecteu to the same ielative uegiee as they weie piotecteu on the petition uate.
So, if a uebtoi's obligations weie 8u% secuieu with maik to maiket collateial on the
petition uate, they shoulu continue to be 8u% secuieu until the uebtoi ueciues to
assume oi ieject, even if the size of the uebtoi's obligations inciease. 0n the othei
hanu, if the non-uebtoi paity was iemiss in allowing the maik to maiket collateial
to uiift below an appiopiiate level, peihaps illustiateu in my 8u% case, the non-
uebtoi paity woulu not be able to seek 1uu% coveiage aftei the bankiuptcy filing.
21
This woulu give the non-uebtoi paity appiopiiate incentives to monitoi anu
ieaujust collateial befoie the onset of financial uistiess - a counteipaity with a fully
collateializeu position will continue to maintain that position thioughout the
chaptei 11 case, but a counteipaity with a lessei position will not be able to
piejuuice othei unsecuieu cieuitois. This shoulu give paities an incentive to aujust
theii collateial on a uaily basis, with the obvious benefit of ieuucing the systemic
effects of a laige uealei's collapse.
89


The continuation of maik to maiket collateial post-petition woulu be a piesumption
that woulu iemain in place until the couit oiueieu otheiwise. Thus, if the uebtoi foi
some ieason felt the continueu posting of collateial was unwaiianteu, it coulu go to
couit to seek a change. The piesumption woulu be tieu to a fuithei piesumption
that the automatic stay woulu be lifteu shoitly aftei the non-uebtoi paity gives
notice that a necessaiy collateial posting has not been maue.
9u


Noieovei, collateial changes not baseu on changes in the unueilying asset values -
foi example, collateial calls baseu on the uebtoi's cieuit iating - woulu not be
piotecteu unuei this iule. They also woulu not be piotecteu unuei the avoiuance
iules, as I uiscuss in fuithei uetail below. Insteau, the goal woulu be to piotect the
piopoitionate uegiee of piotection that the non-uebtoi paity hau at the
commencement of the case.

As pait of this, Congiess also neeus to ieexamine section Su7(b) of the Bankiuptcy
Coue, which pioviues a supei piioiity claim foi a cieuitoi who was gianteu
auequate piotection that tuineu out to be inauequate. In a woilu with contiolling
secuieu bank lenueis, with peivasive liens on all the uebtoi's assets, that often
become contiolling chaptei 11 BIP lenueis, this piovision is apt to be little comfoit,
as section S64(c)(1) gives the BIP lenuei an even highei piioiity.
91
Cieuitois of all
types ueseive bettei anu moie iealistic piotection against juuicial valuation eiiois.




89
Cuiiently collateial posting is a function of both the exposuie of the "in the
money" paity (the "Secuieu Paity" in ISBA teims) anu any applicable "Inuepenuent
Amounts." )"" /8#,$ note 19. In auuition, the paities sometimes agiee to a
"thiesholu" unuei which collateial will not be exchangeu, meaning that collateial is
only exchangeu if the ueiivative piice moves outsiue a kinu of "toleiance inteival."
0ne auuitional effect of allowing ongoing maik to maiket collateial uuiing chaptei
11 at the pie-bankiuptcy ielative level woulu be to move all thiesholus to zeio.
9u
Aftei filing the notice, the bankiuptcy couit woulu have to have a shoit peiiou of
time, peihaps 24 houis, to auuiess any claims by the uebtoi that the non-uebtoi
paity hau impiopeily uemanueu the collateial in question.
91
)"" B"4",$%%: }ay Lawience Westbiook, <(" ?.4',.% .* O"$%'( 24 6$47,8#'9:, 82
Tex. L. Rev. 79S (2uuS).
22
-P !"'$2424B $ A$,,.>"5 !"#. )$*" +$,-.,

In pait II I uesciibeu how the expansion of the safe haibois with iegaiu to
iepuichase agieements hau likely contiibuteu to the iecent financial ciisis, yet theie
is a tiauitional coie of the iepo maiket that seems woithy of saving. This is
paiticulaily obvious with iegaiu to iepos useu by the Feueial Reseive system as an
instiument of monetaiy policy. Noieovei, I suggesteu that the maigins involveu in
these tiauitional tiansactions aie so slight that they might not ieauily accommouate
the imposition of any seiious bankiuptcy costs.

The pioblem then is the cuiient bieauth of the iepo safe haiboi: it coveis things
that look like ioutine secuieu loans anu guaiantees. When useu as such, theie is no
ieason why the foim of the tiansaction shoulu leau to special tieatment of the non-
uebtoi paity. To naiiow the potential foi abuse of the safe haibois, I suggest two
changes to the uefinition of "iepuichase agieement" in the Coue.
92


Fiist, the cuiient uefinition allows foi special status even if the iepuichase
obligation is up to a yeai in the futuie. The ability to use iepo agieements as
substitutes foi othei stiuctuies woulu be ieuuceu if time peiiou weie substantially
ieuuceu, peihaps to Su oi 6u uays.

Seconu, the 2uuS Amenuments, which gianteu special status to iepos baseu on
secuiitizeu collateial - namely moitgage loan secuiities - shoulu be iolleu back.
Repuichase agieements coulu continue to be wiitten on "ineligible" collateial, but
the paities woulu assume gieatei iisks if they ueciueu to uo so.

Taken togethei, these changes woulu pieseive the safe haibois foi the benefit of
shoit-teim contiacts wiitten on highei-quality collateial.

9P <2@" E2@2'/ .4 F//8@#'2.4 $45 !"_"9'2.4

The Coue expiessly attempts to give a ieoiganizing uebtoi a bit of "option value" by
allowing it to make the assumption oi iejection uecision in connection with the
foimulation of a ieoiganization plan. But in the case of ueiivatives, the extieme
volatility associateu with these contiacts aiguably takes the iange of possible
outcomes, anu haim to the non-uebtoi, beyonu those contemplateu by Congiess in
1978.

A non-uebtoi counteipaity will be somewhat piotecteu fiom these soits of iisks by
the continuation of maik to maiket collateial aiiangements, as uesciibeu above.
But foi those counteipaities that lack such piotection, anu because ueiivatives often
foim pait of a laigei investment plan that may be helu in abeyance while the uebtoi
ueciues what to uo, it makes some sense to limit the amount of time the uebtoi can

92
11 0.S.C. 1u1(47).
2S
take to make its uecision.
9S
That is, the Coue shoulu put an expiiation uate on the
uebtoi's option. The time limit shoulu allow the uebtoi a ieasonable oppoitunity to
ieview its positions anu make a uecision as to whethei a paiticulai agieement
shoulu be assumeu oi iejecteu, while ensuiing that the examination pioceeus with
all possible haste.
94


Closely ielateu to this, section S6S(c) of the Coue, which allows foi opeiation of a
business uuiing bankiuptcy "in the oiuinaiy couise" without piioi couit appioval,
shoulu be amenueu to expiessly pioviue the uebtoi with the ability anu .-%2B$'2.4
to peifoim unuei its ueiivative contiacts penuing a uecision to assume oi ieject the
same. Requiieu peiiouic payments shoulu be maue, secuiities ueliveieu, anu, of
couise, collateial posteu. Non-peifoimance shoulu leau to quick teimination of the
automatic stay.

5P ?.52*:24B `H,524$,: ?.8,/"a $45 `!"$/.4$-%: G\823$%"4' N$%8"a

While I have aigueu that counteipaities have little to feai fiom the Coue's avoiuance
actions, theie is some unceitainty about the uefinition of ceitain key teims, which
might cieate an oppoitunity to biing litigation, paiticulaily if a suit is biought by
cieuitois with no othei souice of iecoveiy.

This issue is easily iemeuieu by pioviuing some inteipietive guiuance in the
Bankiuptcy Coue. Foi example, the Coue's piefeience piovisions pioviue a uefense
foi tiansactions unueitaken in the "oiuinaiy couise of business."
9S
A piovision in
the Coue that maue cleai that actions taken accoiuing the expiess teims of an
inuustiy stanuaiu ueiivative contiact woulu be piesumeu to be in the "oiuinaiy
couise," woulu ieuuce much of the incentive foi unwaiianteu piefeience
litigation.
96


Similaily, "constiuctive" fiauuulent tiansfei piovisions unuei state anu feueial law
aie baseu on the iuea that a puichase of the uebtoi's assets foi less than ieasonably
equivalent value can be avoiueu. A piovision in the Coue pioviuing that a ueiivative
tiansaction uone on "maiket teims" is piesumptively foi "ieasonably equivalent
value" woulu be similaily useful, anu shoulu ieuuce the unceitainty that the
avoiuance poweis piesent.

9S
Foi seveial yeais the Coue has hau a similai piovision with iegaiu to non-
iesiuential ieal estate leases, although aiguably the 2uuS amenuments may have
oveily constiicteu the time the uebtoi has in this iegaiu. 11 0.S.C. S6S(u)(4).
94
While shoit timelines no uoubt will cause the uebtoi to incui auuitional
piofessional fees, which ieuuces the oveiall value of the estate, the balance of the
economic losses woulu seem to tilt towaiu ieuucing the peiiou of unceitainty foi
non-uebtois.
9S
11 0.S.C. S47(c)(2).
96
0f couise, this coulu not extenu to 2#/. *$9'. piovisions, lest the piefeience
uefense become a new safe haiboi.
24

Iv. Conclusion

The safe haiboi piovisions aie unloveu, paiticulaily by legal acauemics. But simple
iepeal of those piovisions may not be appiopiiate, in that the financial maikets will
nevei ietuin to 1978. The Bankiuptcy Coue neeus to ieflect the cuiient ieality of
coipoiate finance, anu thus I have suggesteu some valiu conceins that aie buiieu
within the oveily bioau safe haibois. If the safe haibois aie iepealeu, this papei
highlights some issues that will have to be consiueieu at the same time.